May 2 (Reuters) - American International Group Inc’s property and casualty business booked its first underwriting profit in two and a half years during the first quarter, as the insurer wrote more premiums at higher prices and reported lower losses.

The long-awaited turnaround in AIG’s property and casualty business helped the company beat analysts’ quarterly profit expectations on Thursday, sending its shares up 3 percent in after-hours trading.

The unit reported a combined ratio of 97.3 percent last quarter, the first time that ratio has dropped below 100 since the third quarter of 2010. A combined ratio below 100 indicates an underwriting profit, meaning an insurer is receiving more in premiums than it is paying out in claims.

“The important thing for this quarter is that the combined ratio improved,” said Josh Stirling, an insurance analyst with Bernstein Research. “That’s the thing people will focus on: they actually made money.”

Insurers have had trouble raising prices in the property and casualty business for some time. AIG has not reported an annual underwriting profit there since 2007, but the first quarter seems to have been a turning point. Travelers Companies Inc , Chubb Corp and ACE Ltd also beat earnings expectations last month, citing higher pricing.

AIG’s property and casualty unit reported operating income of $1.6 billion in the first quarter, up from $1 billion a year earlier. Its first-quarter, property-and-casualty underwriting income of $231 million compares with a $180 million underwriting loss in the same period a year ago.

AIG’s life insurance business also reported some improvement, with higher returns on alternative assets and gains on the value of securities held in its investment portfolio. Its operating income rose to $1.4 billion from $1.3 billion a year ago. But like other life insurers, the business is still navigating a low interest-rate environment that hurts interest income from bonds and makes it difficult to sell fixed annuities.

Overall, AIG’s profit fell 35 percent to $1.98 billion, or $1.34 per share, from $3.05 billion, or $1.71 per share a year earlier. On an operating basis, AIG earned $1.34 per share, compared with an average analyst estimate of 87 cents per share, according to Thomson Reuters I/B/E/S.

The profit decline was related to lower premium income because of special items, including foreign currency fluctuations. Excluding those factors, net premiums rose 4 percent compared with the year-ago period. AIG also spent more to upgrade infrastructure, technology and personnel, driving expenses higher.

In a memo to employees obtained by Reuters, Chief Executive Robert Benmosche called it a “strong quarter,” but said further improvement was needed.

“Our priority this year is to improve operating fundamentals and reduce costs,” he said. “Whether this means lowering the cost of capital, re-engineering our systems, or focusing on business lines and geographical locations that make strategic sense for our company, each one of us should be looking for ways to improve efficiencies and eliminate expenses.”

The March quarter was an important benchmark for AIG, because it was the first in which the U.S. government had fully exited all its bailout-related holdings.

The Federal Reserve and Treasury Department together offered $182 billion in combined support for AIG stemming from the 2008 financial crisis. After years of restructuring, selling assets and returning its government-owned stock to the public, AIG eliminated the government’s last financial interest in March when it bought back warrants from the Treasury for about $25 million.

DIVIDEND QUESTION LINGERS

Despite that progress, there are still some questions hanging over AIG, including how it will be treated under its presumed status as a “systemically important financial institution,” or SIFI, which the Federal Reserve has not yet officially designated, and when it will be able to resume dividend payments.

AIG shares have risen 19 percent this year, closing at $42.13 on Thursday. But they remain well below the company’s book value of $59.39, excluding market gains and losses.

Analysts say investors are hesitant to value AIG as richly as other insurers because of its bailout, its volatile earnings since 2007 and its ongoing turnaround plan.

While management is investing in some long-neglected areas of AIG, overall it is trying to reduce costs and staff. Benmosche also wants AIG’s property and casualty business to produce a return-on-equity of at least 10 percent and a coverage ratio of 90 to 95 by 2015.

Some investors are also waiting for the company to reinstate its dividend, which has been suspended since 2008. The company has so far offered cautious guidance on that topic.

While resuming dividend payments is important to management, AIG’s first priority is getting ratings agencies and regulators comfortable with its capital levels, executives have said.

AIG has also been using excess capital to buy back some of its more expensive debt and its stock.

The company called $1.1 billion of junior subordinated notes and spent $1.3 billion buying back debt during the first quarter, which will reduce interest payments by $165 million a year. AIG is also considering calling another $750 million in callable hybrids in the second quarter, which would save it another $50 million in annual interest payments.

“I would love to be able to put a dividend on the stock,” Benmosche said in a conference call in February.

But he also noted that ratings agencies “want more time to see us continue to evolve with the good, solid earnings that you’ve seen so far.”